Second Quarter Recap

As we mercifully conclude the first half of 2008, investors are continuing to face the “perfect storm” of adverse circumstances. What began one year ago as a “credit crunch” supposedly isolated and contained in the U.S. economy’s financial sector has now morphed into a global crisis. The subsequent massive de-leveraging and persistent weakness in the U.S. dollar has caused real estate (residential and commercial) and financial assets (stocks and most bonds) to suffer severe declines in value. These declines are continuing as I write… Coupled with huge increases in the cost of food, gasoline, and other commodities, we are faced with zero (or less) economic growth and rising inflation. Consumers understandably have gone “into the bunkers” fearing a return to the Jimmy Carter days (for those of you old enough to remember). These are some of the factors responsible for the stock averages dropping 20% from their October 2007 highs. What has the Federal Reserve been doing during this period?

To be fair, the Fed has been between a rock and a hard place. After months of misjudging the severity of the credit crunch, the Federal Reserve moved aggressively to cut interest rates to aid the financial system (culminating in the Bear Stearns bail-out) at a time of U.S. dollar weakness and rising inflation. The inflation genie seems to be “out of the bottle” led by oil which has risen from $80.00 to over $140.00 per barrel since last fall. These higher energy prices (unless they dramatically decline) could threaten both of the Fed’s primary objectives i.e. price stability and employment growth. The Wall Street Journal recently reported “for all the pain being caused by the credit crunch, managing the oil shock could become the Fed’s main focus in the months ahead. In a speech last month, Federal Vice Chairman Kohn suggested high oil prices could force the Fed to allow both unemployment and inflation to drift higher rather than risk tilting the balance too far in either direction.” Indeed, Fed Fund futures are indicating the markets expect a series of Fed tightenings over the next six months despite near-recessionary economic growth. Against this backdrop, interest rates in June have moved up and credit spreads have widened dramatically. Even Treasury securities have suffered as investors flee the “safety” trade and focus instead on their negative real return. With nothing other than commodities working, what is our strategy for the balance of the year?

My investment approach for 2008 has been to prepare clients for a 1990 type stock decline (19.56%) followed by a 25% rise over the next 12 months. The surge in the price of oil threatens to undermine this strategy as its increasing price clearly will further depress stock prices. If oil continues to surge, another 5-10% decline in stock price is in the cards. However if the price of oil and related commodities drops substantially due to weakening global demand, dollar-strengthening or some other reason, then the oversold equity markets will stage an impressive rally. The duration of the rally will be dependant on the depth and longevity of the oil price decline.

Disclaimer: The information in this blog is based on data gathered from sources that we believe are reliable. However, we do not guarantee the accuracy or completeness of this information. This commentary should not be used as the primary basis for investment decisions, nor is it considered to be investment advice meeting the specific investment needs of any investor.

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